July 2, 2003

Mr. Jonathan G. Katz
Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

Re: Comments Regarding Commission's Hedge Fund Roundtable (File No. 4-476)

Dear Mr. Katz:

The Investment Company Institute¹ appreciates the opportunity to respond to the Securities and Exchange Commission's most recent solicitation of comments with respect to its review of the hedge fund industry.² The Institute previously submitted a statement for inclusion in the public record of the Commission's roundtable on hedge funds, which was held on May 14-15, 2003.³ Enclosed is a memorandum prepared by two of the Institute's senior economists addressing a topic discussed at the roundtable: the reported performance of hedge funds compared to diversified equity mutual funds and the possibility of making private, unregulated hedge funds publicly available to average investors.

The memorandum points out that many recent reports about hedge fund performance statistics substantially overstate hedge funds' actual performance. In particular, many discussions about average hedge fund returns are based on hedge fund indexes with significant biases. These indexes exhibit upward performance biases while exhibiting downward biases with respect to risk measurements.

Hedge fund indexes used to compute total return and other performance statistics contain biases because these indexes are not representative of the universe of hedge funds. In fact, no universal database exists that contains the records of all hedge funds, both those currently operating and those that have ceased operating.

Instead of a universal database, several commercial databases are available that contain subsets of the universe of hedge funds. Not only is the performance based on such database indexes not representative of the universe, it is quite likely that the database indexes overstate the performance of hedge funds generally. This is because these indexes do not contain a random sample from the hedge fund population but instead tend to contain better performing funds, as poorly performing funds have little incentive to report to the data services. In fact, several researchers have estimated that hedge fund indexes may overstate hedge fund returns by 2 to 3 percentage points per year, based solely on their analysis of one bias-the survivorship bias (i.e., the fact that the indexes do not have a complete record of funds that have ceased operations).

The memorandum states that, with respect to risk measurements, several researchers have concluded that hedge fund strategies appear to be one situation in which the use of standard deviation, the most commonly used measure of investment risk, is not appropriate. Because hedge funds do not have bell-shaped normal distributions, hedge funds are more likely to have larger losses than would be indicated by the standard deviation of those returns. Indeed, if relied on to measure hedge fund risk, standard deviation will typically significantly understate the actual degree of risk. In addition, hedge funds contain other important sources of risk, including leverage and illiquidity, which are not captured by standard deviation.

The memorandum concludes that hedge funds are significantly more risky than is commonly portrayed. Investing in hedge funds is a complicated task that requires financial acumen and advanced analytical tools that are typically beyond the reach of individual investors. Given the current state of knowledge, hedge funds or hedge fund investment strategies would not seem to be warranted for average individual investors.

We appreciate the Commission's consideration of our comments. If you have any questions or need additional information, please contact me at (202) 326-5815, John Rea at (202) 326-5910 or Brian Reid at (202) 326-5917.

Sincerely,

Craig S. Tyle
General Counsel

Attachment

cc: Chairman William H. Donaldson
Commissioner Cynthia A. Glassman
Commissioner Harvey J. Goldschmid
Commissioner Paul S. Atkins
Commissioner Roel C. Campos

Paul F. Roye, Director
Division of Investment Management

U.S. Securities and Exchange Commission

¹ The Investment Company Institute is the national association of the American investment company industry. Its membership includes 8,688 open-end investment companies ("mutual funds"), 556 closed-end investment companies, 110 exchange-traded funds, and six sponsors of unit investment trusts. Its mutual fund members have assets of about $6.475 trillion, accounting for approximately 95 percent of total industry assets, and 90.2 million individual shareholders.

² SEC Press Rel. No. 64 (May 22, 2003).

³ See Statement of the Investment Company Institute, Securities and Exchange Commission Roundtable on Hedge Funds, April 30, 2003.